[By Divyani Auti ]
The author is a student at the Maharashtra National Law University, Nagpur.
As the world enters into an era of financial austerity amidst an economic slowdown brought about by the Covid-19 pandemic, the restrictive regulatory stance of the Reserve Bank of India (RBI) in relation to cross-border flow of capital has been attracting considerable attention lately. In recent years, there has been an increase in Overseas Direct Investment (ODI) from India and consensus seems to be evolving in favour of liberalizing the current framework to facilitate such investments. At a broader level, such outflow of capital has been happening in two ways: first, expansion of business operations through cross border mergers and acquisitions to facilitate wider access to overseas markets (internationalisation); second and more commonly, incorporation of foreign holding companies by Indian entities to take advantage of favourable regulatory framework (externalisation). Against this backdrop, this post advocates the rationalisation of the regulatory framework governing such cross-border investment whilst highlighting the practical challenges associated with the current framework. In particular, this post shall examine the setting up of step-down subsidiaries overseas and critique the differential treatment meted out to resident individuals. It will then conclude by tracing the round-tripping concerns underlying the prevailing stance and suggest potential changes to help strengthen the framework.
Overseas Direct Investment in India
It is a known fact that investors look for ways to maximise their returns, while businesses look to raise capital from newer markets. This brings into sharp focus the need to find ways to overcome barriers to the cross-border flow of capital. There are many strategic incentives for internationalisation/externalisation, foremost of these being access to capital from global investors resulting in the diversification of investor base. This way, companies don’t have to solely rely on domestic investors who have typically shown less appetite for nascent companies. Also, establishing holding companies offshore provides for greater commercial certainty due to consistency in adjudication, mitigates tax risks, and protects against currency fluctuation. Here, it is pertinent to mention that Foreign Exchange Management Act, 1999 (FEMA) along with FEMA 120 Regulations govern the ODI framework in India.
India’s Regulatory Approach And Impact On International Investors
Recently, the RBI issued clarifications stating that under the FEMA 120 Regulations an Indian party is not permitted to acquire a stake in a foreign company that already has Foreign Direct Investment (FDI) in India. This observation is significant as it characterises even instances wherein an Indian Party doesn’t hold a controlling stake in the overseas company, which in turn has a downstream investment in India as a contravention of applicable law. To better understand the implications of this, let us consider the case of an individual (Indian Party) holding a single share, with no power to influence investment decisions in the overseas company (ODI approval route). Under the current framework, it is entirely plausible that even this would be considered as a joint venture (JV) and consequently, the liability imposed would be disproportionate and can have the effect of curbing entrepreneurial vision.
Similarly, RBI also clarified that FDI in India through a foreign JV/wholly-owned subsidiary (WOS) in which an Indian Party has invested shall require specific approval of RBI. Again, this is crucial as even if it is a limited embargo it affects foreign investors looking to invest in India by increasing compliance costs. In fact, having such an onerous regulatory framework at a time when global supply chains are getting disrupted will not only be ill-suited but will also disincentivise businesses through FDI in India. Crucially, this being an insertion under Frequently Asked Questions (FAQ) and not a change in law, it can further have the effect of calling into question existing investment arrangements, which can lead to uncertainty.
In view of these concerns, a High-Level Advisory Committee was constituted which recommended easing these restrictions to attract foreign investment. It emphasised the need to do away with RBI approval as long as the investments are routed through proper banking channels and are for legitimate business purposes. However, despite such strident calls for liberalisation, these measures have continued to elude the Indian framework.
Overseas Direct Investments in Joint Venture/Wholly Owned Subsidiary
The RBI’s restrictive stance towards ODI can be seen from its earlier embargo on ‘resident individuals’ from investing in overseas companies. Prior to the 2013 Amendment, the FEMA 120 Regulations only permitted an ‘Indian Party’ to invest overseas. While at first glance, this may be seemingly innocuous, however, it is crucial to note that the definition of ‘Indian Party’ did not extend its coverage to ‘resident individual’. Instead, only a company, statutory body and partnership firm were covered under this definition. This predictably came with its own practical challenges as in contrast to FEMA 120 Regulations, the Liberalised Remittance Scheme (LRS) notwithstanding such embargo allowed individuals to get remittance for the purchase of securities. As a result of these divergent stances, it is not inconceivable that individuals already made remittances which resulted in the acquisition or setting up of businesses abroad. Therefore, the Kishori J. Udeshi Committee apprehending such a scenario characterised such restrictions as a ‘handicap’. It further observed that the provisions of then FEMA precluded resident individuals from acquiring the majority stake or establishing business outside India and consequently recommended liberalising the framework to achieve greater capital account convertibility.
Thereafter, in a move affirming the Committee’s observations, the 2013 Amendment permitted resident individuals to invest in equity shares and compulsorily convertible preference shares (CCPS) of JV/WOS outside India. The Amendment, although was welcomed by India Inc., was a fragmented effort at best. This was because the proposed framework whilst permitting the resident individual to set up JV/WOS abroad prohibited setting up or acquisition of a step-down subsidiary. In other words, the JV/WOS was only permitted to the extent that it was an operating entity and not a holding entity. Further still, notwithstanding the 2013 Amendment which expanded the ‘Indian Party’ definition to include ‘resident individuals’ thereby permitting individuals to invest overseas, the definitions of JV and WOS under FEMA 120 Regulations are yet to incorporate such expanded interpretation of ‘Indian Party’.This has given rise to a peculiar situation wherein the ‘resident individuals’ are permitted to make overseas investment under one definition whilst being barred under another. This uncertainty if further compounded when we look that the clarifications under FAQs which permit a resident individual to invest in JV/WOS. Thus, as things stand today, a pall of uncertainty prevails over setting up of step-down subsidiaries. Towards this end, there is a need felt for clarifications to be issued to address this legislative vacuum.
Further, it is crucial to expound upon the reasons behind why such step-down subsidiaries have been prohibited. The conservative approach of RBI can be traced to its long-standing policy of prohibiting multi-layered structures as it apprehends them from being misused to carry out round-tripping of funds and tax evasion. Round-tripping can be understood as domestic funds being improperly channeled out through offshore entities and subsequently entering the domestic economy through direct investment. RBI views setting up such step-down subsidiaries by a JV/WOS as a multi-layered structure that could be used as a smokescreen to carry out illicit activities. Especially since these structures are often characterised by poor regulatory oversight and with the holding companies being typically located in foreign jurisdictions, the investors often lack control overuse of funds. Therefore, notwithstanding the importance of such multi-layered structures for commercial advancement, the RBI continues to prohibit them.
Investments in Other Overseas Entity
At this point, it is clear that a step-down subsidiary set up under a JV/WOS which has been invested in by a resident individual fails to withstand legislative scrutiny. The question that arises now is whether such an embargo similarly extends to an investment made in other overseas entities. In such context, Regulations 4 and 22 under FEMA 120 illustrate instances including acquiring foreign securities through bonus/rights issue on existing investment or acquiring foreign securities as a gift among other ways that provide useful a template for such examination. Here, since the step-down subsidiary is set up by the foreign company and not the resident individual, the investment does not contravene FEMA 120 Regulations. This is predicated on the understanding that the conditions stipulated under the 2013 FEMA Amendment do not cover instances of investments made in other overseas operating entities, especially if the funds have been raised through other investors or its own accruals. Thus, the argument of checking round-tripping advanced by RBI to prevent setting up of step-down subsidiaries seems misdirected as, in any case, entities other than resident individuals are not barred from creating such structures nor is partaking in investment in other overseas entities prohibited. Hence, RBI’s restrictive stance can no longer be justified on the grounds of curbing round-tripping and is instead only causing regulatory hurdles in business operations.
RBI’s complete embargo on resident individuals from setting up step-down subsidiaries and a partial embargo on investment in India through a foreign JV/WOS with an Indian Party whilst ostensibly aimed at preventing round-tripping of funds is nevertheless ill-conceived. Even if we assume round-tripping concerns as a reason behind preventing the establishment of multi-layered structures such as step-down subsidiaries, this still fails to explain why such an embargo is only limited to ‘resident individual’ and not similarly extended to other entities within the definition of ‘Indian Party’ who could also misuse such colourable structures. Beyond this, again assuming RBI’s round-tripping concerns, it is further unclear why there is a lack of restriction in making investments through other ways such as acquiring foreign securities through bonus/rights issue or as a gift from a non-resident when investing in other overseas entities. Taken together, these factors highlight the fallacy in the current policy and the need for establishing a more coherent framework.
Thus, while there is merit in RBI’s intent, the current policy framework nevertheless tends to overreach by creating hurdles and must be liberalised to facilitate business operations. One way to address RBI’s round-tripping concerns is to have higher disclosure requirements to ensure that the interests of the Indian government and foreign investors are reconciled whilst also facilitating a favourable regulatory environment to ensure ease of doing business.
 Regulation 2(k), FEMA 120 Regulations.
 Regulation 20A, FEMA 120 Regulations.
 Point A.6, Schedule V, FEMA 120 Regulations.
 Regulation 2(m) and Regulation 2(q), FEMA 120 Regulations.
 Regulation 4 and Regulation 22, FEMA 120 Regulations.